Questions on third-party RIA audits

SEC Commissioner Daniel Gallagher's proposal that RIAs be required to hire third-party examiners to audit their operations shouldn't be rushed

Jun 1, 2014 @ 12:01 am

A proposal by SEC Commissioner Daniel Gallagher that registered investment advisers be required to hire third-party examiners to audit their operations is worthy of consideration, but action shouldn't be rushed.

Though Mary Jo White, chairman of the Securities and Exchange Commission, called the idea “creative,” questions must be answered before such a proposal is put formally before all the commissioners. A key concern: What evidence exists that current SEC audits of registered investment advisers are missing significant amounts of fraud against investors?

Mr. Gallagher has posited that because the SEC audits only 9% of advisers under its authority, a large amount of malfeasance is going undetected. But he offers no proof. One would expect that if SEC audits had uncovered many cases of investors' being harmed by what the agency calls “deficiencies,” Mr. Gallagher would support his case by citing those figures.

(See also: Advisers worry about potential costs of third-party exams)

The amount of fraud discovered in a random sample of 9% should indicate the level of fraud in a universe fairly accurately. After all, pollsters can get a good read on the likely outcome of elections from much smaller samples.


According to the SEC's annual report, 80% of exams by the SEC or self-regulatory organizations identify deficiencies; 35% find “significant deficiencies,” which might damage investors. But only 13% of those are referred to enforcement for action. Unfortunately, the report does not differentiate percentages of significant deficiencies found at investment advisers versus broker-dealers.

Assuming evidence of serious deficiencies at many investment advisers, and accepting that hiring outside examination experts is required, the next question is how much that would cost each advisory business. A related question concerns audit frequency. Would they be required of every firm every year, two years, three years? Only 46% of brokers are audited annually.


According to one compliance expert, a routine audit can be done for less than $10,000 and would cost about $5,000 at most firms. That figure would be widely acceptable, even for small firms. Some firms might find $20,000 acceptable if it wasn't an annual expense. But uncertainty about those estimates should worry advisers.

The price tag could be much higher, judging by the cost of a business' custody audit. According to Jonathan Roberts, senior vice president of Klingenstein Fields & Co., the bill for a custody audit is about $20,000. That would hit small firms hard if an operations audit carried similar expense.

Another consideration: Are there less expensive ways to achieve better oversight of investment advisers?

Some have suggested they would be willing to pay an annual fee to help finance hiring additional SEC staff to conduct expanded examinations. Why hasn't the agency embraced that idea, which seems to be the simplest solution?

Mr. Gallagher still likes the idea of Finra's conducting the audits as a backup to the SEC. Investment advisers staunchly oppose that, arguing that Finra does not have the knowledge of the investment advisory field.

Could changes to Finra's operations or attitude make this proposal palatable to investment advisers? How much would it cost to bring the regulator up to speed on investment advisory operations and issues? Who would cover those costs? What fee would Finra charge advisers for doing the audits?

Many advisers have argued for a separate SRO for registered investment advisers, but the SEC has not moved in that direction, and such an approach likely would imply higher costs for advisers.

Because there are so many open questions about the best way to confirm that investment advisers are in compliance with securities laws, the SEC should not rush to Mr. Gallagher's position. Instead, it should take the time to determine how often investment advisory firms need to be examined to ensure that investors are being treated fairly.

The SEC must assess all proposals and select the one that is most cost effective, remembering that the investing public ultimately will bear the price — directly by paying higher fees, or indirectly by receiving fewer services.


What do you think?

View comments

Recommended for you

Sponsored financial news

Upcoming Event

Apr 30


Retirement Income Summit

Join InvestmentNews at the 12th annual Retirement Income Summit - the industry's premier retirement planning conference.Much has changed - and much remains to be learned. Attend and discuss how the future is full of opportunity for ... Learn more

Featured video


On the red carpet with Tom James and others at Icons & Innovators

Reflections from Jeffrey Gundlach, Edmund Walters and more at the New York City event

Latest news & opinion

8 podcasts advisers listen to when they aren't working

Listening to podcasts for the fun of it.

UBS continues to cut loans to recruits, while increasing compensation to brokers

The wirehouse reduced recruitment loans 20% and increased bonus loans 68% in the first quarter.

Things are looking up: IBDs soared in 2017

With revenue up, interest rates rising and regulation easing, IBDs are soaring.

SEC advice rule may give RIAs leg up over broker-dealers

Experts say advisers will be able to point to their role as fiduciaries as a differentiator in the advice market.

Brokers accept proposed SEC rule on who can call themselves an adviser

Some say the rule will clear up investor confusion, but others say the SEC didn't go far enough.


Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.


Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print